In early February, the SEC approved of rule changes by the NYSE and Nasdaq that are necessary to shorten the settlement cycle to T+2. The approved rule changes relate to the calculation of ex-dividend dates and several other administrative procedures that I don’t understand. The exact rules that were changed aren’t particularly important; what is important however is that yet another task on the T+2 to-do list has been checked off.
I recently listened to the recording of the session “Be Prepared For T+2” from last year’s NASPP Conference. (This was a great panel, by the way. So great that we’ve asked the panelists to give a repeat performance for our April webcast. Be sure to check it out.) Here are a few things I learned from the panel.
Why T+2? It’s All About Risk
The move to T+2 is industry driven, rather than a push from regulators, with the goal being to reduce risk in the settlement process. Currently trades are settled through a central counter-party, which you know as the DTCC (Depository Trust & Clearing Corporation). One of the DTCC’s roles is to guarantee delivery of shares to the buyer and cash to the seller. If, over the three-day settlement period, either one of these parties flakes out, the DTCC steps in to make the non-flaking party whole.
This requires cash. With securities worth $8.72 billion changing hands every day on the US markets, it requires a lot of cash. The panelists described it as a big suitcase of cash held by the DTCC that can’t be used for anything else. But the DTCC isn’t your rich uncle; this cash is provided by various market participants (such as brokerage firms).
If we can shorten the settlement cycle, the inherent risk is reduced, and less cash is needed to guarantee settlement. This frees up cash that market participants can use for other, presumably better and more profitable, purposes.
Remember Y2K?
The process of changing to T+2 is not dissimilar to what we all went through back when we were preparing for the new millennium. It’s not terribly complex, but there are a lot of rules and processes that have to be reviewed, updated, and tested.
The Securities Industry and Financial Markets Association (SIFMA) and the Investment Company Institute (ICI) have formed an Industry Steering Committee to define the path to T+2. (They even have their own website and a nifty logo, because any self-respecting industry-wide initiative needs a logo.) The steering committee commissioned Deloitte & Touche to prepare a T+2 Playbook detailing all of the changes that have to take place to shorten the settlement period by a day. Europe moved to T+2 in 2014 and apparently there were some lessons learned during that process.
What About T+1? Or T+0?
The consensus of the panel is that T+1 is a long ways off. Moving to T+2 merely requires that the current processes speed up. Moving to T+1 would require real-time clearance; that’s a fundamental change to the entire settlement process. You can rest assured that you’ll have plenty of time to get use to T+2 before having to worry about T+1.
Wait, There’s More!
Stay tuned! On Thursday I’ll discuss the steps you should be taking to prepare for T+2. Also, don’t miss our April webcast, “Be Prepared for T+2.”
There’s a lot being said about the new CEO pay ratio disclosure rules, most of it far better than anything I could write myself, so today, as a fill in for Jenn Namazi who is on vacation, I continue my new tradition of “borrowing” other blog entries on this topic.
Today’s entry is a nifty “to do” list for preparing for the CEO pay ratio disclosure that Mike Melbinger of Winston & Strawn posted in his August 6 blog on CompensationStandards.com. Given that the disclosure isn’t required until 2018 proxy statements, you might have been lulled into thinking that this isn’t something you have to worry about yet. While it’s true that there’s no need to panic, there is a lot to do between now and 2018 and it is a good idea to start putting together a project plan now to get it all done. Don’t let this turn into another fire that you to put out. Here are Mike’s thoughts on how to get started:
1. Brief the Board and/or the Compensation Committee as to the final rules and the action steps. Press coverage of the rules has been extensive. They are likely to ask.
2. Each company may select a methodology to identify its median employee based on the company’s facts and circumstances, including total employee population, a statistical sampling of that population, or other reasonable methods. We expect that the executive compensation professionals in the accounting and consulting firms very soon will be rolling out available methodologies (they began this process when the rules were proposed, two years ago). The company will be required to describe the methodology it used to identify the median employee, and any material assumptions, adjustments (including cost-of-living adjustments), or estimates used to identify the median employee or to determine annual total compensation.
3. As I noted yesterday, the rules confirm that companies may use reasonable estimates when calculating any elements of the annual total compensation for employees other than the CEO (with disclosure). Assess your ability to calculate precisely all items of compensation or whether reasonable estimates may be appropriate for some elements. The company will be required to identify clearly any estimates it uses.
4. Begin to evaluate possible testing dates. The final rules allow a company to select a date within the last three months of its last completed fiscal year on which to determine the employee population for purposes of identifying the median employee. The company would not need to count individuals not employed on that date.
5. Consider tweaking the structure of your work-force (in connection with the selection of a testing date). The rules allow a company to omit from its calculation any employees (i) individuals employed by unaffiliated third parties, (ii) independent contractors, (iii) employees obtained in a business combination or acquisition for the fiscal year in which the transaction becomes effective. Finally, the rule allows companies to annualize the total compensation for a permanent employee who did not work for the entire year, such as a new hire. The rules prohibit companies from full-time equivalent adjustments for part-time workers or annualizing adjustments for temporary and seasonal workers when calculating the required pay ratio.
As I noted yesterday, the rules permit the company to identify its median employee once every three years, unless there has been a change in its employee population or employee compensation arrangements that would result in a significant change in the pay ratio disclosure.
6. Determine whether any of your non-U.S. employees are employed in a jurisdiction with data privacy laws that make the company unable to comply with the rule without violating those laws. The rules only allow a company to exclude employees in these countries. (The rules require a company to obtain a legal opinion on this issue.)
7. The rules only allow a company to exclude up to 5% of the company’s non-U.S. employees (including any non-U.S. employees excluded using the data privacy exemption). Consider which non-U.S. employees to exclude.
8. The rules allow companies to supplement the required disclosure with a narrative discussion or additional ratios. Any additional discussion and/or ratios would need to be clearly identified, not misleading, and not presented with greater prominence than the required pay ratio.
The rules explicitly allow companies to apply a cost-of-living adjustment to the compensation measure used to identify the median employee. The SEC acknowledged that differences in the underlying economic conditions of the countries in which companies operate will have an effect on the compensation paid to employees in those jurisdictions, and requiring companies to determine their median employee and calculate the pay ratio without permitting them to adjust for these different underlying economic conditions could result in a statistic that does not appropriately reflect the value of the compensation paid to individuals in those countries. The rules, therefore, allow companies the option to make cost-of-living adjustments to the compensation of their employees in jurisdictions other than the jurisdiction in which the CEO resides when identifying the median employee (whether using annual total compensation or any other consistently applied compensation measure), provided that the adjustment is applied to all such employees included in the calculation.
If the company chooses this option, it must describe the cost-of-living adjustments as part of its description of the methodology the company used to identify the median employee, and any material assumptions, adjustments, or estimates used to identify the median employee or to determine annual total compensation.
Companies with a substantial number of non-US employees should seriously consider the ability of apply a cost-of-living adjustment to the compensation measure used to identify the median employee.
Last week, the SEC adopted the final CEO pay ratio disclosure rules. I’ve been on vacation, so I don’t have a lot to say about them, but Broc Romanek’s blog on ten things to know about the rules is better than anything I could have written anyway, so I’m just going to repeat that here:
1. Effective Date is Not Imminent (But You Still Need to Gear Up Now): We can look forward to new “Top 10″ Lists in a couple years. Highest and lowest pay ratios. Although the rules aren’t effective until the 2018 proxy statements for calendar end companies, you still need to start gearing up, considering the optics of your ultimate disclosures. The rules do not require companies to report pay ratio disclosures until fiscal years beginning after January 1, 2017.
2. You Don’t Need to Identify a New Median Employee Every Year! This is the BIG Kahuna in the rules! A big cost-saver as the rules permit companies to identify its median employee only once every three years (unless there’s a change in employee population or employee compensation arrangements). Your still need to disclose a pay ratio every year—but you don’t have to go through the hassle of conducting a median employee cost analysis every year. During those two years when you rely on a prior-calculated median employee, your CEO pay is the variable.
3. Pick Your Employee Base Within Three Months of FYE: The rules allow companies to select a date within the last three months of its last completed fiscal year to determine their employee population for purposes of identifying the median employee (so you don’t count folks not yet employed by that date—but you can annualize the total compensation for a permanent employee who did not work for the entire year, such as a new hire).
4. Independent Contractors Aren’t Employees: Duh.
5. Part-Time Employees Can’t Be Equivalized: The rules prohibit companies from full-time equivalent adjustments for part-time workers—or annualizing adjustments for temporary and seasonal workers—when calculating pay ratios.
6. Non-US Employees & the Whole 5% Thing: For some reason, the mass media is in love with this part of the rules. The rules allow companies to exclude non-U.S. employees from the determination of its median employee in two circumstances:
– Non-U.S. employees that are employed in a jurisdiction with data privacy laws that make the company unable to comply with the rule without violating those laws. The rules require a company to obtain a legal opinion on this issue—can you say “cottage industry”!
– Up to 5% of the company’s non-U.S. employees, including any non-U.S. employees excluded using the data privacy exemption, provided that, if a company excludes any non-U.S. employee in a particular jurisdiction, it must exclude all non-U.S. employees in that jurisdiction.
7. Don’t Count New Employees From Deals (This Year): The rules allow companies to omit employees obtained in a business combination or acquisition for the fiscal year in which the transaction took place (so long as the deal is disclosed with approximate number of employees omitted.)
8. Total Comp Calculation for Employees Same as Summary Comp Table for CEO Pay: The rules state that companies must calculate the annual total compensation for its median employee using the same rules that apply to CEO compensation in the Summary Compensation Table (you may use reasonable estimates when calculating any elements of the annual total compensation for employees other than the CEO (with disclosure)).
9. Alternative Ratios & Supplemental Disclosure Permitted: Companies are permitted to supplement required disclosure with a narrative discussion or additional ratios (so long as they’re clearly identified, not misleading nor presented with greater prominence than the required ratio).
10. Register NOW for the Proxy Disclosure Preconference and August 25 Pay Ratio Workshop:Register now before the discount ends next Friday, August 21. The Proxy Disclosure Preconference will be held on October 27, in advance of the NASPP Conference in San Diego. Registration for the Proxy Disclosure Preconference also includes access to a special online Pay Ratio Workshop that will be offered on August 25. The Course Materials will include model disclosures and more. Act by Friday, August 21 to save!
Last Wednesday, the SEC proposed the last set of compensation-related rules required under Dodd-Frank: clawback policies. This is one of those things where the SEC can’t directly require companies to implement clawback provisions, so instead, they are proposing rules that would require the NYSE and NASDAQ to add the requirement to their listing standards for exchange-traded companies.
Clawback Policies
The requirements for clawback policies under Dodd-Frank are much broader than under SOX (which required misconduct and applied only to the CEO and CFO). Here’s the gist of the SEC’s Dodd-Frank proposal:
Applies to all officers (generally the same group subject to Section 16) and former officers
Clawback is triggered by any material noncompliance with financial reporting standards, regardless of whether intent, fraud, or misconduct is involved
Applies only to incentive compensation contingent on the financial results that are subject to the restatement (interestingly, this includes awards in which vesting is contingent on TSR or stock price targets)
Recoverable Amount
The amount of compensation that would be recovered is the excess of the amount paid over what the officer is entitled to based on the restated financials.
In the case of awards in which vesting is contingent on TSR or stock price targets, the company would have to estimate the impact of the error on the stock price. Which seems a little crazy to me. But I didn’t take a single math, science, economic, or business course in college so my understanding of what drives stock price performance is most charitably described as “rudimentary.” Perhaps this is more straightforward than I think.
In the case of equity awards, if the shares haven’t been sold, the company would simply recover the shares. If the shares have been sold, the company would have to recover the sale proceeds (good luck with that). If you weren’t in favor of ownership guidelines and post-vesting holding periods for executives before, this might change your mind, possession being nine-tenths of the law and all. Check out our recent webcasts on these topics (“Stock Ownership Guidelines” and “Post-Vest Holding Periods“)
Disclosures
In addition to requiring a clawback policy, the SEC has also proposed a number of disclosures related to that policy:
The policy itself would be filed with the SEC as an exhibit to Form 10-K.
Companies would be required to disclose whether a restatement that triggered recovery of compensation has occurred in the past year.
If a restatement has occurred, the company must disclose the amount of compensation recoverable as a result of the restatement and the amount of this compensation that remains unrecovered as of the end of the year. For officers for whom recoverable compensation remains outstanding for more the 180 days, the company must disclose their names and the amounts recoverable from them.
For each person for whom the company decides not to pursue recovery of compensation, the company must disclose the name of the person, the amount recoverable, and a brief description of the reason the company decided not to pursue recovery.
More Info
For more information, check out the NASPP alert on this topic. The memos from Ropes & Gray, Jenner & Block, and Covington, as well as Mike Melbinger’s blogs on CompensationStandards.com, were particularly helpful to me in writing this blog (in case you don’t want to read all 198 pages of the SEC’s proposal).
As expected (and as I blogged last week), the SEC has issued a proposal for the pay-for-performance disclosure required under Dodd-Frank. Proxy disclosures aren’t really my gig, so I don’t have a lot more to say about this topic. Luckily, Mike Melbinger of Winston & Strawn provided a great bullet-point summary of the proposed disclosure in his blog on CompensationStandards.com. I’m sure he won’t mind if I “borrow” it.
The proposed rules rely on Total Shareholder Return (TSR) as the basis for reporting the relationship between executive compensation and the company’s financial performance.
Based on the explicit reference to “actually paid” in Section 14(i), the proposed rules exclude unvested stock grants and options, thus continuing the trend to reporting realized pay. Executive compensation professionals will need to sharpen their pencils to explain the relationship between these figures and those shown in the Summary Compensation Table.
For equity-based compensation, companies would use the fair market value on date of vesting, rather than estimated grant date fair market value, as used in the SCT.
The proposed rules also would require the reporting and comparison of cumulative TSR for last 5 fiscal years (with a description of the calculations).
The proposed rules would require a comparison of the company’s TSR against that of a selected peer group.
The proposed rules would require separate reporting for the CEO and the others NEOs—allowing use of an average figure for the other NEOs.
The proposed rules would require disclosure in an interactive data format—XBRL.
Compensation actually paid would not include the actuarial value of pension benefits not earned during the applicable year.
The proposed rules would phase in of the disclosure requirements. For example, in the first year for which the requirements are applicable [2018?], disclosure would be required for the last 3 years only.
The proposed rules exclude foreign private issuers and emerging growth companies, but not smaller reporting companies. However, the proposed rules would phase in the reporting requirements for smaller companies, require only three years of cumulative reporting, and not require reporting amounts attributable to pensions or a comparison to peer group TSR.
A Few More Thoughts
In the NASPP’s last Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting), usage of TSR targets for performance awards increased to 43% of respondents. With this new disclosure requirement, will even more companies jump on the TSR-bandwagon?
At least there’s one bit of good news: the disclosure covers only the NEOs, not a broader group of officers as was originally feared.
More Information
To learn more about the proposed regs, check out our NASPP alert, which includes a number of practitioner memos. The memo from Pay Governance includes a nifty table comparing the SEC’s definition of “actual” pay to the SCT definition of pay, traditional definitions of realized and realizable pay, and the ISS definition of pay.
It’s beginning to look this is going to be the year of Dodd-Frank rulemaking at the SEC. We may have the CEO pay-ratio disclosure rules by the end of the year, the SEC recently proposed rules for hedging policy disclosures, and now the SEC appears poised to propose the pay-for-performance disclosure rules this week.
Readers will recall that Dodd-Frank requires the SEC to promulgate rules requiring public companies to disclose how executive compensation related to company financial performance (see my blog entry, “Beyond Say-on-Pay,” August 5, 2010). In his April 24 blog on TheCorporateCounsel.net, Broc Romanek noted that the SEC has calendared an open Commission meeting for this Wednesday, April 29, to propose the new rules.
Broc’s Eight Cents
Broc offered eight points of analysis on this disclosure:
1. Companies can get the data and crunch the numbers. I don’t think that the actual implementation itself will be difficult.
2. But I think what could be particularly worrisome is having yet another metric to figure out what the CEO got paid and trying to explain all of it.
3. You know how companies have different schemes for granting equity, including type and timing. If the rules tend to try to fit everyone into a narrow bucket in order to try to line everyone up for comparability, and a company’s program doesn’t quite fit neatly into it, then the disclosure can get even more complicated.
4. There are two elements: compensation and financial performance. What is meant by “financial performance” for example? Maybe the SEC will just ask for stock price, maybe they’ll go broader.
5. A tricky part likely will be the explanation of what it all means—and how it works with the Summary Compensation Table.
6. I don’t think it will be difficult to produce the “math” showing the relationship of realized/realizable pay relative to TSR and other financial metrics, so long as:
– There’s a tight definition of realized pay
– We know what period to measure TSR (and if multiple periods can be used)
– We know what other performance measures can be included (if any) and if they can be as prominent in the disclosure as TSR
7. Another area of potential difficulty is explaining why there is not a tight or tighter correlation with TSR (“we use metrics other than TSR to drive our compensation; thus, the correlation is not very strong; on the other hand, our compensation is based on Revenue Growth and EBITDA Margin, and as Exhibit II demonstrates, the correlation is very significant”).
In addition, Dodd-Frank has no requirement for a relative ranking, and companies will need to decide if TSR and Pay should be put in some type of relative context (“relative to our peers, our realizable pay was well below the peers; so even though compensation is not tightly aligned with stock price performance the last 3 years, we did not pay our bums very much).
8. I think what may be the most difficult to address is a requirement to discuss what the Compensation Committee plans to change—and why is it now that it has performed the analysis?
Let’s Make It a Dime; Here’s My Two Cents
I’m not sure that the problem with executive compensation is that companies aren’t disclosing enough information about it. Isn’t this what the CD&A is for? Isn’t this why the stock performance graph is included with the executive compensation disclosures?
Moreover, does anyone think that any company will just come out and say that their executive compensation is not based on or tied to company performance in any way? I’m just not sure that public companies need one more disclosure to try to convince their shareholders that the amount of compensation they are paying to their executives is justified by the company’s performance.
In somewhat of a surprise announcement, last week the SEC proposed rules to implement the requirement under the Dodd-Frank Act that companies disclose their policies with respect to hedging by employees and directors.
This Has Nothing to Do With Yard Work
Hedging is a means by which investors protect themselves against downside risk—think “hedging your bets.” This is all well and good for the average investor, but when the investor in question is an officer or director of the company who has received compensatory awards of stock and/or options, hedging can be problematic. Companies grant equity awards to align their officers and directors with shareholders and to motivate them to increase the value of the company’s stock. If the officers and directors can use hedging instruments to protect themselves from downside risk, they might be less motivated by their equity awards.
Likewise, where a company has implemented ownership guidelines, if officers and directors can hedge against the stock they own to comply with the guidelines, then the guidelines aren’t terribly effective because officers and directors haven’t really assumed the risk of ownership.
More Controversial Than You Might Think
The proposal was issued via written consents of the Commissioners, rather than an open meeting, which is why it caught many of us by surprise. An open meeting would have been announced in advance and people that follow the SEC’s meeting schedule would have known it was happening.
I thought that this ought to be relatively simple—essentially, “disclose your hedging policy”—especially since companies are already doing this for their NEOs in the CD&A. But I guess nothing that the SEC does is very simple; the proposing release is 103 pages long. That is, however, shorter than the CEO pay ratio disclosure proposal, which clocked in at 162 pages.
Part of the complexity is that there are virtually an infinite number of possible types of arrangements and instruments that can be used to hedge a financial position. Complicated strategies like equity swaps, variable prepaid forward contracts, and collars (in case you are wondering, I have no idea what any of these things are, except that I do know that an equity swap is not the same thing as a swap exercise) and more straightforward transactions such as a short sale (I know what that is: a short sale is selling stock you don’t own yet—you are hoping the stock price will decline before you have to buy the stock to close out your position).
The SEC requests comments on a number of matters related to the rules, including:
Should the disclosure apply to all employees (the language included in Dodd-Frank) or just officers and directors (the individuals investors are probably most concerned about when it comes to hedging)?
Should the rules be part of corp governance disclosures under Reg S-K Item 407 or part of the Say-on-Pay disclosures under Item 402? The proposal includes them under Item 407, which means that shareholders technically aren’t voting on them as part of Say-on-Pay.
Types of equity securities that should be subject to the disclosure.
Should companies be required to disclose hedging activities that employees, officers, and directors have engaged in?
Should smaller reporting companies or emerging growth companies be exempted from making the disclosure or subject to a delayed implementation schedule?
Comments should be submitted to the SEC by April 20, 2015.
Cooley’s blog has a nice summary of the proposal, if you don’t want to read all 103 pages.